Week 8:

Financial Statement
Analysis &
Performance

Introduction
Analysis of financial statements for
decision-making
Assessment of a business past, present
& anticipated future.
To identify the weaknesses & strengths.
Financial ratios are tools to do this.

Liquidity ratios
Activity ratios
Gearing ratios
Profitability ratios

Liquidity Ratios
Measures whether a firm can repay
its bills, or financial obligations
(debts) on time.
Focus is on cash or near cash assets
more readily available to settle
debts (especially current debts).

LO 2

Current Ratio (CR)

Sometimes called the working capital
ratio or bankers ratio
Measures a companys ability to pay its
current liabilities.
Computed as follows:
Current Assets
Current Ratio =
Current Liabilities

The higher the CR, the more liquid the

firms position.
Rule of thumb, CR should be > 2.

LO 2

Current Ratio
The current ratio for Lincoln Company is
computed below.
2012
Current assets 2011
$550,000
Current liabilities$210,000
Current ratio

$533,000
$243,000

2.6

2.2

$550,000

$533,000

$210,000

$243,000

LO 2

Quick Ratio (QR)

Measures the instant debt-paying
ability of a company
Sometimes called acid-test ratio.
It is computed as follows:
Quick Assets
Quick Ratio =
Current Liabilities
Quick assets are cash
and other assets that
can be easily
converted to cash.
Does not include
inventory &
prepayments.

LO 2

Quick Ratio (QR)

Quick Ratio =

Current Assets Inventory Prepayments

Current Liabilities

Better measurement of liquidity as

inventory & prepayments are illiquid,
i.e. cannot be converted to cash
quickly.
Rule of thumb, QR should be > 1.

LO 2

Quick Ratio
The quick ratio for Lincoln Company is
computed below.
Quick assets:
Cash
Temporary Investments
Accounts receivable (net)
Total quick assets
Current liabilities

2012
2011
$ 90,500 $ 64,700
75,000
60,000
115,000 120,000
$280,500 $244,700
$210,000 $243,000

Quick ratio

1.3
$280,500
$210,000

$244,700
$243,000

1.0

LO 2

Working Capital
= Excess of current assets over
current liabilities.
Note: not a ratio.
Often used to evaluate a companys
ability to pay current liabilities.
Computed as follows:
Working Capital = Current Assets Current
Liabilities

The larger the figure, the better.

Activity Ratios
Measures how effectively a firm
uses its assets to generate
revenue.
Also called efficiency, turnover or
business asset management
ratios.

LO 2

Inventory Turnover
The relationship between the volume of
goods (merchandise) sold and inventory.
Assesses the efficiency of a firm in
managing its inventory.
Tells how many times the inventory is
replaced/sold within an accounting
period
The higher the figure, the better sales
are increasing & inventory levels are low.
Computed as follows:
Inventory
Turnover =

Cost of Goods
Sold
Average Inventory

LO 2

Inventory Turnover
Lincolns inventory balance at the
beginning of 2011 is $311,000.
2012

Cost of goods sold

Inventories:
Beginning of year
End of year
Total
Average (Total 2)

2011

$1,043,000

$820,000

$311,000
283,000
$594,000
$297,000

$
$

283,000
264,000
547,000
273,500

Inventory turnover
$1,043,000
$273,500

3.8
$820,000
$297,000

2.8

LO 2

Number of Days Sales in

Inventory
A rough measure of the length of
time it takes to purchase, sell, and
replace the inventory.
Computed as follows:
Average
Inventory
Average Daily Cost
of Goods Sold
(Cost of Sales)
Cost of Goods Sold/Cost of
Sales

Number of Days
=
Sales in Inventory

365

LO 2

Number of Days Sales in

Inventory
The number of days sales in inventory
for Lincoln Company is computed below.
2012
Average Inventory
$273,500
Average daily cost of goods sold$2,858

2011
$297,000
$2,247

Number of days sales in inventory

$273,500
$2,858

95.7

$297,000
$2,247

13

LO 2

Accounts Receivable Turnover

= The relationship between sales and
accounts receivable.
Collecting accounts receivable as quickly as
possible improves a companys solvency.
The higher the ratio, the more effective the
firm in collecting from its credit customers.
Computed as follows:
Accounts Receivable
Turnover =

Net Sales
Average
Accounts
Receivable

LO 2

Accounts Receivable Turnover

The accounts receivable turnover for
Lincoln Company is computed below.

2012
2011
$1,498,000 $1,200,000

Net sales
Accounts receivable (net):
Beginning of year
$
End of year
Total
$
Average (Total 2)
$

Accounts receivable turnover

120,000 $
115,000
235,000 $
117,500 $

140,000
120,000
260,000
130,000

12.7

$1,498,000 $1,200,000
$117,500
$130,000

9.2

LO 2

Number of Days Sales in

Receivables
An estimate of the length of time (in days)
the accounts receivable have been
outstanding.
The fewer number of days, the more
efficient the firm is at collecting receivables.
Average
Computed as follows:
Number of Days =
Sales in
Receivables
Net
Sales
365

Accounts
Receivable

Average Daily
Sales

LO 2

Number of Days Sales in

Receivables

The number of days sales in

receivables for Lincoln Company is
computed below.
2012

2011

Average accounts receivable

(Total accounts receivable 2)$ 117,500$
130,000
Net sales
$1,498,000 $1,200,000
Average daily sales
(Net sales 365)
$
4,104 $
3,288
Number of days sales in receivables
28.6
$117,500
$4,104

$130,000
$3,288

39

Fixed Assets/Non-Current AssetsLO 3

Turnover Ratio
Measures how effectively the firm
uses its non-current assets to
generate sales.
The higher the ratio, the more
efficient the firm is in using its noncurrent assets to generate sales.
Net Sales
Computed
=
Non-Current
asAssets
follows:
Turnover

Gross sales
sales returns discounts

Non-Current
Assets (net)

Non-current assets
provision for
depreciation

LO 3

Total Assets Turnover Ratio

A measure that shows how effectively
a company utilizes its assets how
much sales a firm is able to generate
from money invested in total assets.
The higher the ratio, the better.
The ratio is computed as follows:
Total Assets Turnover
Ratio

Net Sales
Average Total
Assets

LO 3

Total Assets Turnover Ratio

The ratio of net sales to assets for Lincoln
Company is computed below.
Net sales
Total assets:
Beginning of year
End of year
Total
Average (Total 2)

2012
2011
$1,498,000 $1,200,000
$1,053,000 $1,010,000
1,044,500
1,053,000
$2,097,500 $2,063,000
$1,048,750 $1,031,500

Ratio of net sales to assets

1.4

$1,498,000
$1,048,750 $1,200,000
$1,031,500

Gearing Ratios
Measures how a firm uses outside
funds (liabilities) to finance its
assets.
Also indicates whether a firm can
pay the interest on the use of
outside funds & repay the loan
amounts.
Also called leverage or debt
management ratios.

LO 2

Debt Ratio
Measures the percentage of total liabilities to the
total assets of the firm.
Computed as follows:
Debt Ratio

Total Liabilities x 100

Total Assets
The lower the ratio, the better
the less a firm is financed by outside parties.
the higher the firms ability to obtain more outside
funds when needed.
High ratio
Funds borrowed can be used to generate higher profits
(but at higher risk)

LO 2

Times Interest Earned Ratio

Measures the number of times a firm
is able to repay fixed interest from its
net operating profits.
Also called interest cover ratio.
The higher the ratio, the better
More able to repay interest charges.

LO 2

Times Interest Earned Ratio

It is computed as follows:
Times Interest
Earned Ratio

Net operating
profit
Interest Expense

Earnings before
interest and tax

LO 2

Times Interest Earned Ratio

The number of times interest charges are
earned for Lincoln Company is computed
below.
2012
Income before income tax
Add interest expense
Amount available to meet
interest charges

2011

$162,500
6,000

$134,600
12,000

$168,500

$146,600

Number of times interest

charges earned
12.2
$168,500
$6,000

28.1

$146,600
$12,000

LO 2

Debt to Equity Ratio

Measures long term debt to
shareholders equity.
Indicates the margin of safety for
creditors.
The lower the ratio, the better for the
firm.
Long term
Debt to Equity
Computed
asRatio
follows:
=
debts

Shareholders
Equity

LO 2

Debt to Equity Ratio

The ratio of liabilities to shareholders equity
for Lincoln Company is computed below.
2012
Long term debts
Shareholders equity

$310,000
$829,500

Debt to Equity Ratio

$310,000
$829,500

2011
$443,000
$787,500
0.4

$443,000
$787,500

0.6

Profitability Ratios
Measures the firms ability to produce
profits from its assets.
The higher the ratios, the better.
Also an indication of firms efficiency.
Can be divided into:
Profitability ratios based on sales (gross profit
margin, net profit margin, operating profit
margin)
Profitability ratios based on assets/resources
(operating profit to total assets ratio, return on
assets ratio, return on common equity)

LO 2

Gross Profit Margin

Measures the profitability of a firm
over a period.
Indicates how much profit is made
per sales generated.
Computed as follows:
Gross Profit Margin = Gross Profit x
100
Net sales

LO 2

Net Profit Margin

Indicates what is available to owners
from its net sales, after considering
all expenses.
Computed as follows:
Net Profit
=
Margin

Net Profit x 100

Net sales

LO 2

Operating Profit Margin

Indicates how much operating profit
is made per sales generated.
Computed as follows:
Operating
=
Profit Margin

Net Operating Profit x

100
Net sales

Earnings before
interest & tax

LO 3

Operating Profit to Total Assets

Ratio
measures the amount of operating
profit obtained from utilising assets.
The higher the ratio, the more
efficient the firm has been in utilising
its assets to generate sales/profit.
It is computed as follows:
Operating Profit to
Total Assets

Net Operating Profit x

100
=
Total Assets

LO 3

Return on Assets Ratio (ROA)

measures the profitability of assets
utilised.
Also known as return on investment
ratio.
The higher the ratio, the better the
return on the use of assets by the
Net Profit After Tax x
Return on Assets Ratio =
firm.
100
Computed as follows: Total Assets

LO 3

Return on Common Equity/

Return on Capital Employed

measures the net profit against the

(ROCE)

amount invested by
shareholders/owners.
Indicates what shareholders/owners
earn from their investments in the
business.
Net Profit After Tax Preferred
Return
on
Common
Equity/
It is computed as
= follows:
Dividends
Capital Employed
Common Equity/Capital

LO 3

Return on Common Equity/

Return on Capital Employed
Lincoln
Company had $150,000 of 6%
(ROCE)

preferred stock outstanding on December 31,

2012 and 2011.
Thus, preferred dividends of $9,000 ($150,000
x 6%) are deducted from net income.
Lincolns common shareholders equity is
determined as follows:

(continued)

LO 3

Return on Common Equity/

Return on Capital Employed
(ROCE)
2012
Net income
$
91,000
Less: preferred dividends
9,000
Total
$
82,000
Common shareholders equity:
Beginning of year
$ 637,500
End of year
679,500
Total
$1,317,000
Average (Total 2)
$ 658,500
Return on common equity

$
$

2011
76,500
9,000
67,500

600,000
637,500
$1,237,500
$ 618,750

12.5%

$82,000

$67,500

$658,500

$618,750

10.9

LO 3

Earnings per share (EPS)

Indicates the net income per share
Earnings per share (EPS) =Net income Preferred Dividends
Number of shares

LO 3

Price earnings ratio (P/E ratio)

Indicates the firms future earnings
prospects
E.g. P/E ratios: A 17, B 24, C 12, D 8.
Market price of A is 17 times more
than its earnings
B has the best future earnings
prospects, as viewedMarket
by investors
price per share
P/E ratio

Earnings per share (EPS)

LO 3

Dividends per share (DPS) &

dividend yield
DPS = dividends/number of shares
Dividend yield = DPS/market price
per share
Rate of return to investors in terms of
cash dividends
Expressed in percentage

LO 3

Inter- & Intra-Company

Comparisons

Inter-company comparisons
against industry averages/norms
Obtained by averaging out the ratios of a
good sample of companies in the industry
Firm can benchmark itself accordingly
Intra-company comparisons
Trend analysis over a period of time
To see if business has improved/ deteriorated
To be used to formulate future strategy